BS2243 Lecture 9 Advertisement. Spring 2012 (Dr. Sumon Bhaumik)

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1 BS2243 Lecture 9 Advertisement Spring 2012 (Dr. Sumon Bhaumik)

2 Why advertise? Building brands Creating markets for new products (scope economies) Price competition / Price protection Barrier to entry Product differentiate

3 Barrier to entry I Enter (-10, -10) Subgames: Start at nodes M, E 1 and E 2 Advertising Incumbent Monopolist (M) No advertising Entrant (E 1 ) Entrant (E 2 ) Do not enter Enter Do not enter (50, 0) (40, 40) (100, 0) There is entry in equilibrium for the subgame starting at E 2, but entry does not happen in equilibrium if the game starts at M There is no entry in equilibrium for the subgame starting at E 1, and there is no entry in equilibrium also if the game starts at M The latter is a subgame perfect equilibrium

4 Barriers to entry II Quantity 2004 US advertising/sales (%) Incumbent s response function Entrant s response function Advertising expense Source: Waldman & Jensen (pp )

5 Product differentiation I Firm 1 Firm 2 s reaction function 45 0 line Differentiated product in Bertrand competition Price in equilibrium significantly higher than MC MC 1 MC 2 Firm 1 s reaction function Firm 2 Recapitulate: without product differentiation, P = MC in equilibrium

6 Product differentiation II Monopolistic competition MC AC Product differentiation implies market power, and hence downward sloping demand curve Firm earns positive economic profit in the short run, but zero economic profit in the long run MR 1 D 2 D 1 Q Inefficiencies: P > MC and hence deadweight loss If profit maximising output is less than the output at which AC is minimised, there is excess capacity

7 Product differentiation III Is there too much product differentiation? Welfare is the sum of consumer surplus and profits If there is entry, there is an increase in consumer surplus, but individual firms ignore this and focus on their private benefits If there is entry, there is a decrease in profits, but individual firms will ignore this as well, and focus on their private benefits The outcome, therefore, is ambiguous; both too much product differentiation and too little product differentiation are feasible Example of inefficient product differentiation A A & B Transportation cost for consumers would have been lower if, in equilibrium, firms A and B did not end up in the middle B

8 Product differentiation and adverse selection Consumers have an informational asymmetry vis-a-vis the sellers This can lead to market failure Example: Used car market 50% of cars are good, and 50% of them are bad A good car is valued at 5000, and a bad car is valued at 1000 A rational customer would not pay more than 3000 for a car Hence, there will be a market failure, i.e., there will be no trades in the used car market Do advertisements increase or decrease the likelihood of adverse selection?

9 Expected impact of advertisement Advertisement expenditure (E = - ) shifts demand curve from D( ) to D( ) P P A C Increase in profit Initial amount (Q) at a higher price (P ) = (P P)Q = A Extra amount (Q Q) at price P = (Q Q)P = B + C B D( ) MC = AC D( ) Strategic question ( - )? (A + B + C) Q Q Implication of economic theory Marginal cost of advertising should equal its marginal benefit

10 Welfare effects of advertisement I D( ) represents pre-advertising preferences, and D( ) represents post-advertising preferences Advertising raises price to P and quantity to Q At pre-advertising preferences: P P A D C Increase in net social welfare = B E (where E is the advertising expense) B D( ) MC = AC D( ) Increase in profit net of advertising expense = A + B + C E Q Q Implication: Private benefit of advertising to firms exceeds the social value of advertising

11 Welfare effects of advertisement II Note also that the following can happen simultaneously A + B + C E > 0 B E < 0 But we cannot have B E > 0 P P A D C B MC = AC unless we also have A + B + C E > 0 Implication: Society cannot benefit from advertising unless the firm s profit rises on account of advertising D( ) D( ) At post-advertising preferences: Increase in social welfare Q Q = B + C + D E B E (if C & D are small) Implication: Fo r small changes in sales, net change in social welfare is roughly the same irrespective of whether or not advertising changes the preferences of the consumers

12 Is there too much advertising? Gains from advertisements Increase in the size of the market Increase in the market share of the firm advertising its product Implication Advertising expenses are likely to be greater under oligopoly than under monopoly Advertising expenses are likely to be (close to) zero under perfect competition Advertising expenses would have an inverted-u relationship with market concentration Firm A: High advertising expenses Firm B: Low advertising expenses Firm B: High advertising expenses {High, High} is the dominant strategy equilibrium. Firm B: Low advertising expenses (100, 100) (130, 80) (80, 130) (120, 120)